Stocks: Bernanke Plays Scrooge

Disappointment with the central bank's moves -- especially its quarter-point discount rate easing -- sparked a sell-off Tuesday

Like a child who got a reindeer sweater instead of the Wii he was secretly hoping for, Wall Street sulked after the Federal Reserve unveiled its holiday present Tuesday. Major U.S. stock indexes each tumbled over 2% after the Fed's policy-setting committee lowered the benchmark Fed funds rate target by 25 basis points to 4.25%, as widely expected.

Fed policymakers also cut the discount rate by 25 basis points to 4.75%. Investors were disappointed that the Fed did not make a more aggressive move amid some market speculation the central bank was going to cut the discount rate by as much as 75 basis points.

While the market was largely preoccupied with the Fed, news that troubled mortgage lender Washington Mutual has slashed its dividend by nearly 75% and expects to take some hefty loan loss provisions seemed to stoke some investor anxiety. Meanwhile, Citigroup culminated its month-long search for a new CEO, appointing Vikram Pandit to the post.

On Tuesday, the Dow Jones industrial average fell 294.26 points, or 2.14%, to 13,432.77. The broader S&P 500 index dropped 38.31 points, or 2.53%, to 1,477.65. The tech-heavy Nasdaq composite index lost 66.60 points, or 2.45%, to end at 2,652.35.

Financials, homebuilders, retailers and Real Estate Investment Trusts all sold down at least 5% following the Fed's announcement, as investors expressed their annoyance with the central bank's lack of urgency about current conditions in the financial markets.

On the New York Stock Exchange, 26 stocks traded lower for every five that were on the upswing, while on the Nasdaq the ratio was 23 to six negative, though trading remained sluggish even after the Fed's decision, S&P MarketScope said.

The Fed said growth "is slowing" and that "strains in the financial markets have increased." Policymakers noted that core inflation has improved modestly, but with elevated commodity prices, they still see some inflation pressures.

The FOMC did not give a clear indication on its policy bias, saying their actions along with the prior easings "should help promote moderate growth over time."

The FOMC note concluded by saying the committee "will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth." That leaves the door open for more easing down the road if necessary, says Action Economics.

As was the case with the October 31 rate cut, the FOMC vote was 9-1, with Eric S. Rosengren dissenting in favor of a 50 basis-point cut in the Fed funds rate.

The rate cut is the third such move by the Fed since August, when the subprime crisis began to worsen. A slumping housing sector, and concerns that subprime losses by big banks could tighten credit, have spurred worries about a pronounced slowdown in U.S. economic growth.

The market's disappointment centered on the Fed's failure to close the gap between the Fed funds rate and the discount rate, said Diane Dercher, chief economist at Waddell & Reed in Kansas City. Cutting the discount rate by at least 50 basis points to 4.50% would have helped overcome banks' resistance to borrowing at the discount window and loosened some of the liquidity restraints, and yet the Fed chose not to do that, she said.

The Fed's unwillingness to be more creative in providing a stimulus is all the more perplexing given that "they're recognizing we’re in the midst of a slowing economy and it’s more than just a housing slowdown," she said. "The disconnect here is that the market is anticipating the economy to be a lot weaker than what it appears the Fed believes and [the Fed] doesn't think they need to do as much as the market believes they need to do."

It would be easier for the Fed to commit to more aggressive action if the economic reports were uniformly showing clear signs of distress, but instead there's been a divergence between weak domestic sectors, such as homebuilders and business investment, and a fairly robust export markets, which the manufacturing industry is benefiting from most, said Keith Hambre, chief economist for Minneapolis-based First American Funds. That divergence is contributing to the cloudiness of the outlook, he said.

"If you look historically, you won’t find the Fed easing by 100 [basis] points with the ISM above 50," he said, referring to the Institute for Supply Management's manufacturing index. The index eased slightly to 50.8 in November and has remained above 50 for the past six months.

For the time being, Hambre predicts that equity indexes will remain in the same trading range they have been in since August. While the S&P 500 index has gotten a lift over the past few weeks from back-to-back speeches by top Fed officers, the Treasury Department's subprime rescue plan and some capital infusions to banks from overseas, forward-looking guidance by the central bank is much more ambiguous as to whether more rate relief is imminent in the near term and that will cause the equity investors to reassess the strength of those markets, he said.

The Dow utility index reached a record high earlier Tuesday on expectations that lower interest rates will draw more investors to utility stocks, whose dividends will start to look more attractive by comparison.

Beyond the immediate reaction to the Fed decision, the equity markets will likely return to the bearish mode they were in for much of November as soon as financial companies start to report further losses, said Matt King, chief investment officer at Bell Investment Advisors in Oakland, Cal.

"There's no change to that until we get our hands around this subprime issue," he said.

While the cash injections into financial companies from overseas investors should be taken positively, King said they represent the view that the weakness in financials is a long-term buying opportunity, something that more prudent investors aren't yet comfortable with.

"It takes a lot of guts to make that move," he said. "It's too early to tell who’s going to benefit from this and who’s going to go under." he said.

The healthcare, utilities and consumer staples stocks are a safe bet even if there's a significant economic slowdown, while another area in which Bell has recently increased its allocation is technology, which hasn't held up as well, despite strong third-quarter earnings.

Further weakness in the U.S. dollar makes overseas investments a good bet, too, he said. Three-quarters of Bell's clients’ assets are currently overseas in unhedged investments, he added.

Earlier in the day, expectations of a rate cut had overshadowed more subprime tremors as Washington Mutual (WM) announced after the market close on Monday that it was cutting 3,150 jobs, and will stop lending through its subprime channel. The largest U.S. thrift also plans to close about 190 of its 336 home-loan centers and sales offices and shut down nine home-loan processing and call centers. The cuts will cost $140 million in the fourth quarter but will pare non-interest expenses by roughly $500 million in 2008, the bank said.

Like many of its peers, Washington Mutual is in need of cash. To that end, WaMu said it's cutting its dividend by almost 75% to 15 cents a share and will sell a chunk of its convertible preferred stock in an effort to raise $2.5 billion. WaMu shares fell 8.3% Tuesday.

In economic news, U.S. wholesale sales rose 0.7% in October, while inventories were flat. September's 1.3% sales increase was revised up a bit to 1.4%, after a 0.8% gain in August. The 0.8% September increase in inventories was adjusted down to 0.6%. October's inventory data are weaker than expected. The report won't have much market impact, but the numbers will help economists fine tune GDP forecasts, Action Economics said.

January NYMEX crude as crude oil futures surged over $90 Tuesday before pulling back to end $1.26 higher at $89.12 per barrel. Driving the gains were pipeline disruptions caused by a giant Midwest ice storm. The energy market was also helped by traders' belief the Fed would cut rates at least 25 basis points to bolster a sagging U.S. economy and increase demand for commodities.

Among the stocks in the news Tuesday, AT&T (T) raised its quarterly dividend 13%, to 40 cents per share from 35.5 cents. The telecom giant also sets a new 400 million-share share buyback. Shares rose 4.1%.

General Electric (GE) said its board has approved an 11% hike in its quarterly dividend to 31 cents a share and has authorized $15 billion in stock buybacks over the next three years. The company also forecast a profit of $2.42 a share in 2008, up at least 10%. The shares closed 0.8% lower, however, since analysts were projecting a profit of $2.49 a share next year. Shares were down 1.0%.

Merck & Co. (MRK) reaffirmed its projections for compound annual revenue growth of 4% to 6% from 2005 to 2010 (including 50% of all revenue from joint ventured) and for double-digit compound annual earnings growth (excluding certain items). The drug manufacturer plans to return gross margin to pre-ZOCOR levels in 2008. Shares ended 0.6% lower.

Medarex Inc. (MEDX) shares dropped 20.9% after Bear Stearns downgraded the stock to peer perform from outperform on disappointing data from a clinical trial for an investigational immunotherapy for patients with metastatic melanoma.

The Kroger Co. (KR) shares dropped 6.6% after it posted a third-quarter profit of 37 cents a share, vs. 30 cents a year ago, on a 9.8% rise in revenue. The fourth quarter will include a benefit from the resolution of certain tax issues. Based on year-to-date financial results and current trends, the supermarket chain now expects identical supermarket sales growth of about 5% for the full year, excluding fuel sales, and expects earnings to slightly exceed a prior forecast of $1.64 to $1.67 a share, including special items.

European stocks finished lower Tuesday. In London, the FTSE 100 index was down 0.43% at 6,536.90. In Paris, the CAC 40 index slipped 0.45% to 5,724.76. Germany's DAX index was off 0.30% at 8,009.42.

Major Asian markets finished higher. Japan's Nikkei 225 index climbed 0.76% to 16,044.72. In Hong Kong, the Hang Seng index rose 2.55% to 29,226.84. The Shanghai composite index edged up 0.25% to 5,175.08.

Treasury market

Treasury yields plunged as investors piled into government bonds on the drop in equity markets after the Fed’s announcement.

The 2-year Treasury note rose 14/32 to 100-11/32 for yield of 2.94%, 10-year notes jumped 1-15/32 to 102-06/32 for a yield of 3.98% and the 30-year bond leaped 2-18/32 to 108-19/32 for a yield of 4.47%.

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